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Risk ManagementRisk managementInterest rate riskSection A

ACCA · Question 08 · Risk Management

Section A

Horizon Builders expects to borrow $10 million in 3 months' time for a period of 6 months. To hedge against rising interest rates, they enter into a 3-9 Forward Rate Agreement (FRA) at 5.0%. When the borrowing date arrives, the reference market interest rate (LIBOR) is 6.5%.

Which of the following statements correctly describes the outcome of the FRA?

Answer options:

A.

Horizon Builders will pay the bank the difference between 6.5% and 5.0%.

B.

Horizon Builders will receive a payment from the bank, compensating them for the higher interest rate.

C.

The FRA will lapse unexercised because it is an option.

D.

Horizon Builders must borrow the funds directly from the bank that sold the FRA at 5.0%.

How to approach this question

Understand that an FRA fixes an interest rate. If you are hedging a borrowing and rates rise above the FRA rate, the seller of the FRA (the bank) pays you the difference.

Full Answer

B.Horizon Builders will receive a payment from the bank, compensating them for the higher interest rate.✓ Correct
A Forward Rate Agreement (FRA) is a binding contract to fix an interest rate. Horizon Builders is hedging against a rise in borrowing costs. Because the market rate (6.5%) is higher than the FRA rate (5.0%), Horizon will borrow in the open market at 6.5% but will receive a cash settlement from the FRA provider for the 1.5% difference, effectively capping their borrowing cost at 5.0%.

Common mistakes

Confusing an FRA with an Interest Rate Guarantee (IRG), which is an option and can be allowed to lapse.
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